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Construction contract retentions: September 2016

Construction contract retentions. GUIDANCE NOTE SEPTEMBER 2016 | CONSTRUCTION CONTRACT RETENTIONS | SEPTEMBER 2016 CONTENTS CONSTRUCTION CONTRACT RETENTIONS 1 Holding retention money in cash or other liquid assets 1 Investing the retention money in accordance with the Trustee Act 1956 4 Using retention money 5 Can the parties alter the legislative parameters of the trust relationship? 6 Going forward 7 | CONSTRUCTION CONTRACT RETENTIONS | SEPTEMBER 2016 | Page 1 CONSTRUCTION CONTRACT RETENTIONS From 31 March 2017, any party (retention trustee) to a commercial construction contract (construction contract) that is withholding money on retention (retention money) from an amount payable to the other party to the construction contract (retention beneficiary), must now hold the retention money "on trust", as trustee, for the benefit of the retention beneficiary. The Construction Contracts Amendment Act 2015 (Act), which introduces this retention regime into the Construction Contracts Act 2002 (CCA), does not detail what is meant by holding retention money "on trust". The retention regime sets out only broad parameters of the trust relationship between the retention trustee and the retention beneficiary. One of the most important duties under general trust law is to obey the terms of the trust. To assist retention trustees with obeying the trust terms, in this guidance note, we discuss the practical implications of the following three key elements of the trust relationship between the retention trustee and the retention beneficiary, as prescribed in the Act:  The retention money can be held either in cash or other liquid assets that are readily converted into cash  The retention trustee can invest the retention money in accordance with the Trustee Act 1956  The retention money can only be used by the retention trustee to remedy defects in the retention beneficiary's performance of its obligations. We will also consider the extent to which the parties can alter the terms of the trust relationship. Holding retention money in cash or other liquid assets The retention trustee is not necessarily required to hold the retention money in cash and can hold it as other liquid assets that are readily converted into cash. The Act does not define what assets would be considered liquid assets that are readily converted into cash. However, in a letter from the Minister of Building and Housing (Minister) to industry representatives (referred to in the book "CCA Handbook: making the Construction Contracts Act work" by Peter Degerholm pages 39-40), the Minister stated: The natural and ordinary meaning of 'liquid asset' is a financial asset that can be converted into cash in a short time with little or no loss in value and can include accounts receivable, demand and time deposits, and securities (such as bonds). The definition of 'financial asset' in New Zealand Equivalent to International Accounting Standards 32 (NZ IAS 32) includes, but is not limited to, a contractual right to receive cash or other financial asset from another entity. The effect of the new provision is that where retentions are withheld under a commercial construction contract, the gross amount is not required to be held in cash to meet the trust obligation. Although reliance on accounts receivable is acceptable to meet the trust obligations in these provisions, conditional payment provisions (pay when paid) clauses in construction contracts remain prohibited. BF\56015113\6 | Page 2 In defining a "liquid asset" the Minister referenced the definition of "financial asset" in New Zealand Equivalent to International Accounting Standard 32 (NZ IAS 32) which provides that a financial asset includes equity, accounts receivable and derivatives. However, the balance of the language in the above quote seems to reflect the definition of "cash equivalents" in NZ IAS 7 which defines cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value". NZ IAS 7 provides guidance about cash equivalents as follows: "Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. Equity investments are excluded from cash equivalents unless they are, in substance, cash equivalents, for example in the case of preferred shares acquired within a short period of their maturity and with a specified redemption date." What can be gleaned from NZ IAS 7 is that, according to the Minister, a liquid asset is an asset which:  Is used as part of the cash-management function of the entity  Is subject to an insignificant risk of changes in value  Matures within three months. To determine whether any particular asset, proposed to be held in lieu of cash for the retention money, is liquid requires a careful examination of the retention trustee’s circumstances and its assets. For example, different organisations use different types of assets as part of their cash-management. Such organisations may classify the same asset differently, depending on how they used the asset. ACCOUNTS RECEIVABLE If a retention trustee (probably a head contractor) was to rely on account receivables to satisfy the trust obligations, the retention trustee will need to:  Ensure that it has, up until the retention money is required to be paid, accounts receivable that both satisfy its accounts payable, from time to time, and can satisfy the aggregate amount of retention money it is withholding, from time to time. The retention trustee could not take into account the retention money payable to it if this was payable later than 3 months from the date of the assessment and could be contingent on the retention trustee remedying non-compliance in its obligations.  The retention trustee will need to be vigilant that the rate of recovery of its accounts receivable is such that it is able to demonstrate that there is an insignificant risk of changes in its face value. Therefore, under the NZS3910 payment regime, contractors cannot simply rely on the claimed amount in its payment claim issued to the principal as recording its account receivable for its different projects because this is potentially subject to adjustment by the engineer and the principal. The contractor will need to make an honest assessment as to the extent that its payment claims under various projects are typically subject to adjustment and the extent of that adjustment (which will obviously be different from project to project and from payment claim to payment claim). BF\56015113\6 | Page 3  In the NZS3910 context, we consider that the retention trustee will, in most instances, likely be able to demonstrate that its accounts receivable (other than retention money payable to it) are convertible to cash within three months because the principal must pay the amount recorded in the progress payment schedule within 17 working days' of the date that the contractor serves its payment claim. However, the retention trustee will need to ensure that there is a clear pattern of on-time payment. DEBT FUNDING In terms of a retention trustee who is an owner using debt to fund a project, the Ministry of Business, Innovation, and Employment's Regulatory Impact Statement: Retentions in construction contracts, dated 21 November 2014 (RIS) assumes that the trust obligation does not apply to such retention trustee, who can continue to draw down only the net amount of a progress payment (ie keeping the retention money as part of the undrawn balance of the loan facility). Commentators have rightly noted that the Act does not reflect this and the retention regime appears to apply equally to retention trustees who are owners using debt to fund their projects. The question is then whether an undrawn amount of a loan facility or an overdraft facility falls within the concept of a liquid asset that is readily converted into cash. There is some doubt as to whether an undrawn amount of a loan facility or an overdraft facility are a liquid asset because it may not be possible to say that they are assets. The Minister relied on accounting principles in developing the concept of liquid assets that are readily converted into cash. According to accounting principles, an asset is "a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity" 1 . Therefore, the definition of asset has three components:  Control (as opposed to ownership)  A past event  Future economic benefits. Control (as opposed to ownership) as a result of a past event The component of control over the asset is linked with the component of the event which gave the retention trustee control over the asset. Accordingly, we will discuss these components together. There are two alternative views:  One view is that the retention trustee achieves control over the asset (cash amounts in an undrawn loan or overdraft facility) by entering into the loan facility agreement. To achieve control, the principal retention trustee would need:  to have satisfied the conditions precedent for the loan facility  a (mostly) unfettered right to draw down on its facility for the purposes of paying retention money (provided the principal is not in breach of its banking covenants). Similarly, a head contractor retention trustee would likely have an unfettered right to withdraw money out of its overdraft facility so long as it is not in breach of its banking covenants and has not overdrawn its facility. Therefore, the past event, for the purposes of an undrawn loan amount or overdraft, is the retention trustee entering into the loan facility agreement entitling the retention trustee to withdraw the amount in the future. 1 New Zealand Equivalent to the IASB Conceptual Framework for Financial Reporting 2010 (NZ Framework), paragraph 4.4(a). BF\56015113\6 | Page 4  The alternative view is that the transaction or event which gives the retention trustee control over the asset is the retention trustee actually withdrawing the amount from its facility which occurs in the future. In other words, whether the retention trustee has control of the (yet to be withdrawn) cash amount is still contingent on certain events occurring or not occurring:  the retention trustee taking action in the future to withdraw the amount. The retention trustee may have been placed in receivership at the time the retention money becomes payable.  the amount is still available to withdraw. The circumstances existing when the retention trustee seeks to withdraw the amount may be significantly different from those which existed at the time when the retention money was supposed to be withheld. The retention trustee may have overdrawn its overdraft or exceeded its facility amount or may have breached its lending covenants (such as by being placed in receivership). This is different from a term deposit where the retention trustee's circumstances do not affect its entitlement to withdraw the term deposit amount. Even ignoring the argument that there is no trust over retention money because there is no actual cash for the trust to attach to, it is difficult to say that the retention trustee has control over the retention money when actual control remains contingent as described above. Future economic benefits For accounting purposes, cash has a benefit because of its command over other resources2 . This could similarly apply to an unfettered entitlement to draw on a loan facility or withdraw from an overdraft facility to use for the purpose of generating economic benefits to the retention trustee. There is some potential uncertainty as to whether the event to secure control of the cash is a past or future event. If it is a future event contingent on the retention trustee still being entitled to draw down on the facility and then actually withdrawing the amount, then it is less clear that an undrawn loan facility or overdraft facility satisfy the definition of an asset. In light of this doubt, the most conservative approach is for a retention trustee to draw down on its loan facility or withdraw the amount of the retention from its overdraft facility and hold it as a positive cash balance. The retention trustee could then deposit the withdrawn amount as a positive cash balance into its standard operating account or into a savings account or a term deposit account (subject to its obligations in relation to investments discussed below) in order to receive interest on this amount that could then (probably partially) offset the interest charged on the amount withdrawn from its loan or overdraft facility. Investing the retention money in accordance with the Trustee Act 1956 The Act provides that the retention trustee can invest the retention money in accordance with the Trustee Act 1956. The retention trustee is not obliged to invest retention money. However, if the retention trustee is not holding retention money as cash and is proposing to invest it, we consider that the retention regime restricts the type of investments that the retention trustee can make using the retention money, to investments that are liquid and readily converted into cash, as discussed above. Notwithstanding this restriction, the retention trustee must still satisfy its investment duties under the Trustee Act when investing within the restricted category of investments permitted under the Act. 2 NZ Framework, paragraph 4.9. BF\56015113\6 | Page 5 The primary duty on the retention trustee under the Trustee Act when investing retention money is to act prudently. This is the case notwithstanding that the retention trustee must cover any losses arising from investing the retention money. In other words, failing to act prudently in investing the retention money would be a breach of trust notwithstanding that the retention trustee was still able to pay the retention money to the retention beneficiary. Section 13B of the Trustee Act outlines the core obligation on the retention trustee when investing retention money. Section 13B provides: Subject to sections 13C and 13D, a trustee exercising any power of investment shall exercise the care, diligence, and skill that a prudent person of business would exercise in managing the affairs of others. Essentially, the Trustee Act requires the retention trustee to act cautiously and with care, applying the standard of a prudent business person (not the standard of a someone without business experience) and the standard which would be exercised when managing other people's money (ie more likely to be careful with someone else's money than your own)3 . The Trustee Act sets out various matters that the retention trustee must take into account (section 13E). Without listing these matters, in the context of retentions, we consider that the retention trustee will need to:  Establish a strategy for the investment of retention money4 that provides for diversification of investments 5  Make investments that:  are relatively low risk to minimise the risk of loss of the retention money  can be quickly converted to cash (the type of investments will need to be ones that give the retention trustee the right to sell down the investment at any time or a specific time, without penalty)  maintain the real value of the retention money (taking into account the likelihood of inflation affecting the value of the proposed investment)  mature around the time the retention money is payable (it would be prudent to have investments mature before the retention money becomes payable; the retention trustee could always reinvest it if payment of the retention money is delayed due to the retention beneficiary needing to remedy defects in the works). Using retention money Section 18E(1) of the CCA is drafted in relatively broad terms and contemplates that retention money may be used to resolve any non-compliance by the retention beneficiary with its obligations under the construction contract6 . In the context of the NZS3910 contract form, it is implicit that retention money can be used to secure:  Pre-practical completion obligations (such as the payment of liquidated damages)  Post-practical completion obligations (such as the rectification of defects). 3 Garrow and Kelly, Law of Trusts and Trustees, 7th edition, Greg Kelly and Chris Kelly, paragraph 21.16. 4 Section 13M(d) of the Trustee Act. 5 Section 13M(c) of the Trustee Act. 6 Section 18E(1) of the CCA provides: "Party A must not appropriate any retention money to a use other than to remedy defects in the performance of party B’s obligations under the contract." BF\56015113\6 | Page 6 Accordingly, pre-practical completion, the retention money could be applied in satisfying, for example, any liquidated damages that may be payable to the retention trustee (principal) where the retention beneficiary (contractor) fails to pay the liquidated damages amount on practical completion. Deduction of the liquidated damages amount from any money payable to the retention beneficiary (including retentions) is contemplated in clause 10.5.3 of NZS3910. Post-practical completion, the retention trustee is not entitled (in NZS3910) to deduct the cost of remedying defects from retentions though the cost of remedying defects is recoverable7 from the retention beneficiary8 . Therefore, the retention trustee will need to include a clause, additional to the NZS3910 General Conditions, allowing it to deduct the cost of remedying defects (similar to clause 10.5.3 of NZS3910 which relates to liquidated damages). Alternatively, it is common to include a general clause, additional to the NZS3910 General Conditions, allowing the retention trustee to set off or deduct from amounts due to the retention beneficiary amounts due from the retention beneficiary to the retention trustee. The terms of the trust will be complied with if the retention trustee sets off its liability to pay the retention money against the retention beneficiary's liability to pay for defects rectified by the retention trustee. Since one of the retention trustee's primary duties is to safeguard the trust fund in the retention beneficiary's interests9 , the retention trustee will need to be vigilant that there are no disputes about whether the retention beneficiary is in breach of any of its obligations (such as to pay liquidated damages or rectify defects) before using the retention money. For example, before it can access the retention money for defects in the works, the retention trustee will need to satisfy various pre-conditions in clause 11 of NZS3910. The most contentious pre-condition is likely to be demonstrating that there is a defect in the works and that the retention beneficiary is responsible for the defect. If the retention beneficiary has failed to remedy the defect within the required time because it disputes that it is responsible for the defect, it would be imprudent for the retention trustee to apply the retention money to the cost of remedying the defect because it would not know whether it has appropriated the retention money for a proper use until the parties agree on the dispute or it is settled by a dispute forum. The retention trustee may land on the wrong side of that dispute. Can the parties alter the legislative parameters of the trust relationship? The retention trustee and the retention beneficiary can alter the terms of the retention regime that are broadly set out in the Act. However, section 18I(2) provides that "Any provision in a construction contract is void if the purpose, or one of the purposes, of the provision is to avoid the application of any of the provisions of this subpart". Therefore, the retention trustee and the retention beneficiary will need to take care to ensure that any changes to the retention regime that they agree in the construction contract are consistent with the regime. 7 Clause 11.2.3 of NZS3910. 8 Clause 11.2.8 of NZS3910 clarifies that defects include:  Loss or damage caused by the Contractor after practical completion (clause 5.6.3 of NZS3910);  Any outstanding as-built drawings and operation and maintenance manuals (clause 5.20 of NZS3910);  Minor omissions and minor defects notified by the Engineer and authorised by the Engineer for later completion under clause 10.4.1 for the purposes of certifying Practical Completion (clause 10.4.1 of NZS3910). 9 Section 18C(1) of the CCA. BF\56015113\6 | Page 7 For example, as mentioned above, if the retention trustee chooses to invest the retention money it must do so in accordance with the Trustee Act 195610 irrespective of what the construction contract states. Therefore, the retention trustee must comply with the duty imposed on trustees when investing trust funds. This is the case even though section 13D of the Trustee Act provides that the duty to invest prudently does not apply if this is permitted in the instrument creating the trust or any legislation. The terms of the trust are set out in the Act and they do not allow for the parties to contract out of the Trustee Act duties imposed on the retention trustee when investing retention money. In some instances, it may be difficult for the parties to determine whether any agreed "contractual" trust terms are inconsistent with the retention regime in the CCA. For example, the parties may agree on what constitutes an acceptable form of assets in which the retention money will be held (noting that such assets will need to be liquid and readily converted into cash and the retention trustee must act prudently when selecting from the accepted types of assets). However, without guidance from regulations or case law as to what constitutes a liquid asset, there is no guarantee that the asset chosen by the parties would be considered a liquid asset for the purposes of the retention regime. The parties will be able to contractually alter the non-prescriptive terms of the regime by agreeing and recording in the construction contract alternative or (say) more stringent obligations on the retention trustee. For example, the parties could agree contractually that, notwithstanding section 18E(2)(a) of the CCA which provides that retention money does not have to be paid into a separate trust account, the retention trustee must hold retention money in a separate account. On the other hand, the retention trustee cannot exclude or in any way alter general trust law duties imposed on it. Section 18C(1) imports these general trust law duties into the regime11 . It is important that the retention trustee becomes familiar with the general trust law duties on trustees. Going forward There will be a lot of new concepts for principals and contractors to understand when it comes to complying with the retention regime. They will need to decide whether they hold retention money as a positive cash balance or whether they will treat debt funding (for principals) or account receivables (for contractors) as liquid assets. If the retention trustee segregates a positive cash balance and chooses to invest it, it will need to ensure it complies with its duties under the Trustee Act. Further, the retention trustee will need to be vigilant that there are no disputes about defects in performance before using the retention money to rectify such defects. There will be limited scope to alter the regime to avoid these issues. However, hopefully any regulations that are enacted or guidance released, by the Government will address some of the practical issues that retention trustees will be facing. AUTHOR BASSAM MAGHZAL Senior Associate DDI: 03 353 5884 | Mobile: 021 227 7266 bassam.maghzal@buddlefindlay.com 10 Section 18F(1) of the CCA. 11 Section 18C(1) of the CCA provides: "All retention money must be held on trust by party A, as trustee, for the benefit of party B".

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